Elasticity

 It is the amount of a variable’s sensitivity upon change of a further variable.

 Economically, elasticity refers to the degree of change of individuals demands in reaction to

price or income changes.

The formula for computing elasticity of demand is:

Ep = Percentage change in quantity demanded

Percentage change in price

• If the elasticity is greater than 1, the demand is elastic. It means that quantity changes faster
than price.

• If the elasticity is less than 1, demand is inelastic – quantity changes slower than price.

• If the elasticity is equal to 1, elasticity of demand is unitary where quantity changes at the same
rate as price.

• Elasticity of demand is a significant variation on the concept of demand and can be classified as
elastic, inelastic or unitary.

Elastic Demand

 Quantity demanded extremely reacts when there is a cheap in price. An example of products
with an elastic demand is those goods not frequently purchased, such as appliances and
furniture and can be deferred if price rises.
Elastic Demand

 Substitute of a product affect the elasticity of demand. If a product can be easily substituted
certainly by another product, consumers will merely shift purchases when there is price
increase/decrease for both goods.

 For example, poultry and fish are both meat products. When there is a diminishing price of
poultry, consumers will shift in buying fish to save costs. So products with close substitutes tend
to have elastic demand.

Inelastic Demand

 A change in price results in only a small change in quantity demanded. Simply the quantity
demanded is not very responsive to price changes.

 Examples of this are daily necessities such as food. When the price of food increases, consumers
will not reduce their food purchases, granting there may be shifts in the types of food they
purchase.

 When the price increases from Php8.00 per unit to 10.00 the quantity sold decreases from 50
units to 45 units. The elasticity coefficient is 0.4
Coefficient –a numerical or constant quantity placed before and multiplying the variable in an algebraic.
- a multiplier or factor that measures some property.
Unitary Elasticity

 A change in price will result to an equal percentage of change in quantity demanded. Thus, the
elasticity coefficient is equal to one.

 When the price decreases from Php8.00 per unit to 4.00 per unit, the quantity sold increases
from 20 units to 40 units. The elasticity coefficient is 1.
Total Revenue

 The total revenue a firm obtains is the price of the good multiplied by the quantity sold.

Total Revenue = Price x Quantity Sold

• Assume that a firm increases the price of its good, there would be a price or quantity effect.

• When the price increases, each unit sold sells for higher price, which tends to raise revenue.

• However, there is no assurance that the consumers will patronize the goods as same as before.
Thus, after a price increase, fewer units might be sold, which tends to lower revenue.

 The price elasticity of demand illustrates what happens to total revenue prices changes.
 Example:

• Suppose the current price of a fish is Php50.00, but that the vendors must raise extra money for
market rent. Will raising the price of the fish to Php55.00 increase or decrease total revenue?

• Suppose 1,000 individuals buy everyday at the current price. So total revenue is:

Total revenue = Php50.00 x 1,000 = Php50,000.00

Let us look at three cases. The Price Elasticity of Demand is a) Inelastic, Ep = 0.5

b) Elastic, Ep = 2.0

c) Unit-Elastic, Ep = 1.0

Case 1: Inelastic Demand

 Suppose the price elasticity of demand is 0.5. What effect will the 10% increase in the fish on
total revenue?

 Solution for the fish @Php55.00

Ep = Percentage change in quantity demanded

Percentage change in price

=Qphp 55 – Qphp 50

Php50

Q55 - 1000

-0.5 = 1000

.10

We know

Ep = 0.5 and Php50.00 =1000

So Qphp55 = 950 and total revenue at the higher price of fish is

Total revenue = Php55 x 950

= Php52,250.00

Case 2: Elastic Demand

 Suppose the price elasticity of demand is 2.0. What effect will the 10% increase in the fish on
total revenue?
 Ep = Percentage change in quantity demanded

Percentage change in price

Qphp 55 – Qphp 50

Php50 Q55 - 1000

-0.5 = Qphp 55 – Qphp 50 -2 = 1000

Php50 .10

In this case Qphp55 = 800 and total revenue at the higher toll would be

Total revenue = Php55 x 800 = Php44,000.00

Case 3: Unit-Elastic Demand

 Suppose the price elasticity of demand is 1. What effect will the 10% increase in the fish on
total revenue?

 A price elasticity of demand of 1 means that an increase in the price leads to an equal percent
decrease in quantity demanded. Thus, if the price increases by 10%, quantity sold will
decrease by 10% too. Needless to say, quantity sold at Php55 will be 900 and total revenue
will be:

Total revenue = Php55 x 900 = Php49,500.00

 According to the law of demand, when a seller decreases his price , he will be able to sell more
goods. However, when the price decreases, it is lessen for each unit of goods.

Total Revenue = Price x Output

Php18 = 9 x 2

24 = 8 x 3

28 = 7 x 4

30 = 6 x 5

30 = 5 x 6

28 = 4 x 7

24 = 3 x 8
  As we move down the demand curve, elasticity drops while total revenue increases. However,
the increase lasts only until the total revenue reach the maximum. Afterwards, as prices
continually drops, demand becomes inelastic and total revenue decrease.

Income Elasticity of Demand

 Income elasticity of demand measures the relationship between a change in quantity demanded
for good and change in income.

The formula for calculating income elasticity is:

Income Elasticity = % change in demand

% change in income
Normal Goods /Inferior Goods

 Normal goods are goods that have proportionate response on its demand as income changes.
These goods have positive income elasticity. Example might be luxury items; as the income level
increases, more people buy or demand them.

 Inferior goods are the goods that have inverse response on its demand as income changes. Thus,
it has negative income elasticity. Typically inferior goods exist when high class or superior goods
are available in the market. An example of an inferior good is public transportation. When
 consumers have less wealth, they may forgo using their own forms of private transportation in
order to down costs.

How do businesses make use of estimates of income elasticity of demand?

 Luxury items with high income elasticity has greater sales impulsiveness over the business cycle
compared to necessities where demand from consumers is less sensitive to changes in the cycle.

 Thus enough understanding of income elasticity of demand helps firms predict the effect of an
economic cycle on sales.

 As one’s wealth become better, they can afford increase in spending on various goods and
services.

Cross Elasticity of Demand

 Most of the times, the demand for one good is influenced by price changes of other goods. It is
calculated by taking the percentage change in the quantity demanded of one good over the
percentage change in price of the substitute good. Thus, cross elasticity of demand is an
economic concept that determines the degree of sensitivity in the quantity demanded of one
good when a change in price takes place in another good.

EAB = Percentage change in quantity of A demanded

Percentage change in price of B

 Since the demand for a substitute good will always increase when the price for the other good
increases, the cross elasticity of demand for these goods will always be positive.
  Let’s take coffee and a substitute drink tea as an example. All other things equal, when the price
of coffee increases , the quantity demanded for tea will increase as consumers switch to an
alternative.

 On the other hand, the coefficient for compliments will be negative. At this point in time, let us
use coffee and creamer as an example. When the price of coffee increases the quantity
demanded for creamer will drop as consumer will purchase fewer. If the coefficient is O, then
the two goods are not related.

Elasticity of Supply

 The analysis and calculation of elasticity of supply is similar to elasticity of demand, except that
the quantities used refer to quantities supplied instead of quantities demanded.

 Supply elasticity is the ratio between change in quantity supplied and the percentage change in
price.

= Percentage change in quantity supplied

Percentage change in price

 Ability to switch to production of other goods, ability to go out of business, ability to use other
resource inputs and the amount of time available to respond to a price change are the factors
that influence the elasticity of supply.

Summary:

Elasticity refers to the degree of sensitivity of individual demands in reaction to price or income
changes. This is important so that we know how demand would react in times of price/income change.
Elasticity may be elastic, inelastic or unitary depending to the coefficient that we calculate from certain
formula. The total revenue is also a related concept to elasticity. It is the amount a firm obtains on its
production. Elasticity would help manufacturers decide in their operations sine it would help them
calculate the amount of return they could get along with a specific change. Moreover, income elasticity
helps businesses predict the effect of an economic cycle on sales. Cross elasticity, however, focuses on
the influence of change of price of other goods to determine the change in demand. Elasticity of supply
uses the same concept with demand, with mere variations in the kind of quantity used.